IPO hype can blind novice investors to valuation. They focus only on the company’s float and overlook valuations of its local and international competitors.
Consider this month’s ASX listing of Guzman y Gomez (ASX: GYG) the fast-growing Mexican-inspired food chain. It’s been hard to pick up a newspaper without reading a story on Guzman, its listing success and debates about its valuation.
Morningstar, a research house, values GYG shares at $15, suggesting its stock is materially overvalued at the current $29.49 But the market couldn’t get enough of GYG. Shares in the tightly held float popped to $30.99 on debut.
GYG has starred in the Australian quick-service restaurant industry. Since 2006, GYG has opened 210 restaurants in four countries: Australia (185 stores), Singapore (16), Japan (5) and the United States (4).
I visited one of its Melbourne stores on the weekend for this column. Inside, the joint was buzzing with mostly twentysomething patrons. Outside a long line of cars snaked around its double-laned drive-through, eager for a burrito or taco.
GYG clearly has a concept that is popular with its target market. Even some high-end restaurant critics have given its food offering better than a pass mark.
But the main issue is valuation. Can GYG accelerate its global store rollout to justify a market capitalisation of almost $3 billion?
For comparison, Collins Food (ASX: CKF) is capitalised at just over $1 billion. Collins has 355 KFC restaurants in Australia, Germany and The Netherlands, and 27 Taco Bell stores, a global Mexican-inspired food chain.
Domino’s Pizza Enterprises (ASX: DMP) is capitalised at $3.32 billion. DMP has more than 3,000 stores across 12 markets.
As GYG achieves a lofty valuation, Collins and Domino’s have lost favour. Collins has fallen from a 52-week high of $14.40 to $9.11 after a volatile week. Domino’s has tumbled from a 52-week high of $59.49 to $36.49, burning investors.
Like other fast-food operators, Collins and Domino’s are battling higher food inflation costs, higher wages and lower consumer discretionary spending in a weak economy. It’s hard to imagine GYG being immune to these problems.
Morningstar values Collin’s Food at $14.40, or about 56% above its current price. Domino’s is also materially undervalued on Morningstar forecasts. Its fair value of $61 a share for Domino’s compares to the current $36.48.
I’m wary of Domino’s, having been burnt by the stock in the past few years. Collins, featured several times in this column over the past five years, is a different story.
Collins reported a better than expected FY24 result this week with 10.4% revenue growth to $1.48 billion year-on-year. But it noted weak consumer sentiment affecting its sales in the first seven weeks of FY25 and ongoing margin pressure. Collins leapt 9% on the result but gave up most of those gains the next day.
Granted, KFC is a mature concept in Australia with lower store-rollout prospects. Also, Collins has overpaid for some of its international assets, which haven’t grown as quickly as expected. Taco Bell has yet again disappointed in Australia, despite being a huge brand in the US fast-food industry.
That said, it’s hard to see how GYG is worth three times as much as Collins at the current price or only a touch below the capitalisation of DMP, which is the world’s largest Domino’s franchisee and an experienced international operator.
Either GYG is badly overvalued, or Collin’s and Dominos are badly undervalued. The answer is a mix of both. I wouldn’t buy GYG at these levels. As readers know, I prefer to buy most IPOs a year or two after listing when the hype fades, early investors have exited and there is more history as a listed entity.
The GYG float was engineered to be successful with a relatively small amount of stock offered. Tailwinds included hype about GYG in a moribund IPO market that desperately needed a big listing; reports of heavy trading in GYG by Gen Z investors on share platforms; and heavy media coverage before and after listing.
Collins, and Domino’s to a lesser extent, look attractive for long-term investors. A slowing economy hurts all fast-food operators, but also true is that cheaper eats, such as KFC and Domino’s, and more defensive that mid-priced offerings like Grill’d, Nandos or GYG.
Chart 1: Collins Food
Source: Google Finance
Chart 2: Domino’s Pizza Enterprises
Source: Google Finance
Prospective investors in fast-food stocks should also consider the world’s two largest operators: McDonald’s Corp and Yum Brands Inc, which owns the KFC, Pizza Hut, Taco Bell and Habit Burger Grill brands. Starbucks Group, the world’s largest speciality coffee chain, is another worth watching.
McDonald’s Corp (NYSE: MCD) looks the pick of them. Shares in the burger giant have slumped from a 52-week high of US$302 to US$257.38, principally on market fears about the weak US economy and its effect on food sales.
In its first-quarter 2024 results, McDonald’s reported sales growth of 2% over the same period last year. That marked 13 consecutive quarters of sales growth, reinforcing McDonald’s defensive qualities for investors.
McDonald’s is executing well on its four D strategy: digital, drive-thru, delivery and development. Digital and delivery sales are growing strongly, and the company’s product development has momentum due to several successful recent promotions. Stronger sales of chicken on its menu is another highlight.
McDonald’s is leveraging is giant global customer base to drive its loyalty program and digital sales. The company is well positioned to capitalise on a faster migration from physical to digital sales.
Moreover, as the largest fast-food operator, McDonald’s has stronger economies of scale to help absorb increases in food costs and greater pricing power to pass on higher costs to consumers.
An average broker price target of US$312 suggests McDonald’s is undervalued at US$257. Roughly two thirds of the 33 broking firms in the consensus forecast have buy or strong buy recommendations on McDonalds. The rest have holds.
So, while Australian investors pay a huge valuation for GYG, the world’s best fast food company is trading at a decent discount to fair value.
With US interest rates expected to be cut well before those in Australia, particularly after this week’s poor local inflation number, the US fast-food sector could improve sooner than ours. Watch McDonald’s increase its market share at the expense of smaller competitors.
Chart 3: McDonald’s Corp
Source: Google Finance
Elsewhere, Starbucks Group (NYSE: SBUX) has caught my attention. Like McDonald’s, the coffee giant is trading well below the consensus broker price target, thanks to weary US consumer demand and a slower-than-expected recovery in China.
Starbucks shares were hammered in May after the coffee chain reported lower same-store sales for the first time in three years.
Against that, Starbucks has been raising prices over the few years to offset rising food and wage costs – a sign of the chain’s pricing power and loyal customer base. Starbucks should benefit from an improving US economy next year and signs that China’s economic malaise is slowing.
Chart 4: Starbucks Group
Source: Google Finance
I’ll do more work on Starbucks in coming weeks. For now, McDonald’s looks the tastiest of the fast-food stocks, with emerging value in local fast-food plays like Collins Food and Domino’s.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at June 27, 2024
